SITREP | Israel's Economic Outlook Clouded by Uncertainty

By IndraStra Global News Team

Cover Image Attribute: The file photo of Tel Avis Stock Exchange / Source: Rina Castelnuovo / Bloomberg.

The recent outbreak of military conflict in the Middle East has sent shockwaves through financial markets, raising concerns about the global economic outlook. This has created significant uncertainty for Moody's credit rating agency as they prepare to evaluate Israel's economy. With the assessment scheduled to take place in less than a week, Moody's is now confronted with the difficult challenge of analyzing the economic consequences resulting from the ongoing conflict, which has disrupted their preparations. The possibility of a credit rating downgrade, which wasn't previously on the table, has now become a real concern. Moody's must evaluate whether Israel's economic situation has reached a critical level, necessitating a reassessment of the country's risk profile.
Israel's economic landscape has seen significant deterioration since the return of former Prime Minister Netanyahu to power last year. This decline is attributed to the political instability stemming from his government's contentious plans to overhaul the judiciary and an increasing geopolitical risk. Risk analysis presents a complex challenge as risks are interconnected and can suddenly escalate, creating unforeseen crises.
As the conflict with Hamas unfolds, key economic indicators such as the exchange rate, stock market indices, and government bond prices must be closely monitored. While it's too early to assess the long-term implications, the reality of the situation demands immediate attention from rating agencies.
The extent of the damage inflicted on Israel's economy by the war remains uncertain, primarily dependent on the conflict's duration. However, unique challenges arise this time, particularly impacting the tourism and events industries. The industrial output in the Ashkelon region, which accounts for about 18% of Israel's total, and the Be'er Sheva region, around 25%, is expected to be affected. Nevertheless, recent studies, including one by the Bank of Israel, suggest that the industrial sector is less sensitive to such events compared to the high-tech industry, which is a vital economic driver.
Past conflicts with Hamas have demonstrated a pattern of temporary GDP declines followed by significant economic rebounds. For instance, the Second Lebanon War in 2006 resulted in a 0.35-0.5% loss in GDP, which was later compensated for by increased economic activity.
Budgetary concerns that arose in the early days of the war, including defense budget demands, often get resolved with less drama as negotiations progress. However, this war's uniqueness, marked by a surprise attack, high casualties, and systemic breakdown, suggests that the damage may be more severe this time.
From a macroeconomic perspective, this war represents a significant threat to Israel's economy, unlike anything seen since the Yom Kippur War in 1973. The country's growth rate, which exceeded 15% in the past two years, is now declining to 3%, signaling a shift from prosperity to stagnation. The growth drivers, including private consumption and investment, have slowed down, resulting in declining tax revenues and a growing deficit.
Moreover, Israel's political and societal polarization in recent months has profoundly impacted the economy, affecting investment, consumption, and public confidence. The government's judicial overhaul has exacerbated the situation, leading to a devaluation of the exchange rate and economic consequences such as inflation and capital flight.
Adding to the economic challenges is the global increase in the cost of money due to a sudden rise in U.S. Treasury bond yields, as a surge in demand for these bonds during times of potential crisis could influence market interest rates. This is causing the dollar to appreciate worldwide, including in Israel. While falling interest rates might typically be seen as a potential driver of inflation by encouraging borrowing and spending, the context of a regional war might lead to a different interpretation, with a focus on the perceived risks to the economy. Overall, this development not only makes it more challenging to raise funds for Israel but also significantly more expensive.
On the other hand, Federal Reserve officials had already been cautious about rising energy prices as a potential risk to their goal of gradually easing inflation. They had also expressed optimism about the U.S. economy avoiding a recession unless an unexpected external shock occurred. With conflict erupting in a major oil-producing region, the reaction of key players like Iran and Saudi Arabia will be closely watched for signs of another oil price surge.

Bankers and Experts Weigh In

For central banks, the conflict presents a dilemma. It could lead to new inflationary pressures, especially given the region's importance in oil production and shipping, or it could blow confidence, causing an economic slowdown. 

• Agustin Carstens, General Manager of the Bank for International Settlements, pointed out that it is too early to predict the full implications of the conflict, but immediate effects could be felt in oil and equity markets. The extent of the impact will depend on the duration and intensity of the conflict, as well as whether it spreads to other parts of the region.

• Carl Tannenbaum, Chief Economist with Northern Trust, noted that any source of economic uncertainty tends to delay decision-making and increase risk. Given the significance of the Middle East in the global oil supply chain, there is apprehension about potential disruptions to oil markets.

Market experts are closely monitoring various scenarios as they unfold. After decades of instability in the Middle East, there is a question of whether this outbreak of violence will have a different evolution and potentially disrupt the long-term economic equilibrium.

• Karim Basta, Chief Economist at III Capital Management, emphasized that the conflict introduces risks to both inflation and economic growth outlooks. The Federal Reserve will need to assess which of these concerns takes precedence.

• Ori Greenfeld, chief strategist at Psagot Investment House, expressed concern that this conflict's economic impact would be more significant compared to previous military engagements in the south of Israel. He emphasized that the financial markets are the lifeblood of Israel's economy, and while past conflicts had minimal effects on the local financial market, the current situation is far less optimistic. Greenfeld highlighted two key factors contributing to the expected economic damage: "First, the war in Gaza is likely to be prolonged, with a significant portion of Israel under constant missile threat, leading to reduced consumer activity. Second, during times of heightened uncertainty, investments in both the private and public sectors are expected to decrease."

The ongoing Middle East conflict is likely to be a major topic of discussion among global financial leaders gathering in Morocco for meetings of the International Monetary Fund (IMF) and World Bank. These meetings provide an opportunity to assess the state of the global economy, which remains in flux due to the ongoing pandemic and rising trade tensions.

Response at Tel Aviv Stock Exchange 

The Tel Aviv Stock Exchange witnessed a substantial drop in share prices on Sunday as investors grappled with uncertainty and concerns about the potential long-term impact on Israel's economy following an unexpected attack launched by the Gaza Strip's Hamas group. 
The TA-35 stock index, which comprises leading blue-chip companies, saw a significant decline of 6.4%, while the benchmark TA-125 index fell by 6.2%. The TA-90 index, tracking shares with the highest capitalization not included in the TA-35 index, also experienced a more than 6% decline. The TA-Bank index, representing the five largest banks in the country, plummeted by 7.8%. Furthermore, shares in the construction, building, and insurance sectors saw sharp drops ranging between 8% and 9%.

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